Lessons of the Fall

Stating up front how much risk a company is willing to take on can save that company a world of trouble, two finance chiefs maintain.David M. Katz, CFO.com | USOctober 27, 2010

It may be hard to believe, but there was at least one positive outcome to the financial hardship that befell companies in the wake of the economic crisis that struck in September 2008: a heightened sense among finance chiefs of how to assess and manage unexpected risks.

That message could be culled from remarks made on Tuesday at the CFO Rising West conference in Las Vegas by two CFOs who work in the insurance and airline businesses — two industries that were among the most affected by the turmoil that followed the fall of Lehman Brothers more than two years ago. The two speakers, Rob Schimek, CFO of Chartis, the largest subsidiary of AIG, and Phung Ngo-Burns, finance chief of ExpressJet, both said the crisis led their companies to clearly state how much and what kinds of peril they are willing to endure for the sake of doing business.

Speaking during a risk-management panel at the conference, Schimek said the most valuable step the property-casualty insurer has taken as a result of the financial crisis has been to develop a "risk-appetite statement" for its entire organization. He recommended that noninsurance companies, both large and small, do the same.

The purpose of compiling the risk-appetite statement was to develop four "guideposts" for the maximum risk Chartis is willing to assume, said Schimek. As a result, he said, when he is asked "how much catastrophe risk or property risk are you willing to take, I've actually already formulated that view in a written document that says 'This is my risk appetite.'"

The four guideposts are derived from asking these questions:

1. How frequently is the company willing to miss an earnings target and surprise investors because it engaged in a certain endeavor? The insurer uses probability calculations to determine the likelihood of such events occurring.

2. How frequently is the company willing to accept a loss of capital? Such an event wouldn't involve merely a loss of current income but an "erosion of our capital base," said Schimek.

3. How frequently would the company "be willing to lose so much capital that it would be forced to go into the capital markets to raise additional capital?"

4. How often would the company take the risk of going insolvent? "Never," Schimek remarked.

While the answers to those questions come from senior management, they are put into effect at the operating levels, where employees now know "how much risk we are willing to take on any insurance policy, with any counterparty, on any individual trade or event — or across our entire portfolio of events," said Schimek.

For her part, Ngo-Burns said that while ExpressJet didn't respond to the economic crisis with a risk-appetite standard, it renegotiated its service contracts in 2008 to incorporate a standardized indemnification-and-waiver agreement. Under the agreement, the airline stated exactly what risks it would self-insure, insure, or avoid entirely (by not doing a certain task) in the course of providing services to airport authorities, airlines, or other parties.

Among the risks for which ExpressJet specified its intentions was the risk that one of its baggage handlers, for example, would be charged with "mal intent" if a passenger's luggage was lost, Ngo-Burns told CFO after the session. She explained that mal intent may simply mean a charge of theft.

Inserting the indemnification-and-waiver agreement into contracts was a way for ExpressJet to tell its clients, "This is where our services begin, and this is where they end," she said.